The big problem with ethical investing

Environmentally conscious investors putting downward pressure on fossil-fuel stocks can actually increase the profit opportunities for investors who are not averse to investing in the industry.

By

DerekTharp

It is often claimed that socially responsible investors—those who incorporate social, environmental or other ethical concerns into the construction of a portfolio—can “do well by doing good.”

To the extent this claim has been challenged, most have examined whether such investors can truly “do well.” From an investment performance perspective, the answer appears to be yes. A 2017 TIAA analysis found no long-term, systematic performance penalties for leading socially responsible indexes relative to broad market benchmarks.

While not all studies have been as favorable toward socially responsible investing (SRI)—a 2008 paper in the Journal of Banking & Finance concluded that “existing studies hint but do not unequivocally demonstrate that SRI investors are willing to accept suboptimal financial performance to pursue social or ethical objectives”—the reality appears to be that differences in performance, if any, are small enough that socially responsible investors can still “do well.”

But it is less clear whether such investors are truly “doing good.” In fact, to make an informed decision about whether or not to engage in socially responsible investment strategies (particularly in light of the added cost that is involved), potential investors should be open to the possibility that such strategies may have little to no impact at all.

Unlike many good deeds we may do in life—picking up trash, donating to a good cause, or helping out someone in need—our actions in the stock market can often be easily (and profitably) reversed by others who may not share our nonfinancial motives.

Suppose a group of environmentally conscious investors decides to engage in fossil-fuel divestment. All else equal, their divestment will put downward pressure on equities within the fossil-fuel industry. Presumably many such investors also hope that such downward pressure will result in consequences such as reduced investment interest, a higher cost of capital for divested firms, corporate policy change, or some other effect that ultimately leads to a world with less fossil-fuel consumption.

But, unfortunately for those who may be motivated by the consequences of their divestment, putting downward pressure on fossil-fuel stocks based on nonfinancial criteria will actually increase the profit opportunities for investors who are not averse to investing in the fossil-fuel industry. Assuming that industry fundamentals remain the same, profit-minded investors can short the stocks overweighted by the environmentally conscious investors (that is, wherever environmentally conscious investors invest their divestment proceeds) and purchase fossil-fuel stocks, effectively canceling out the downward pressure socially responsible investors intended to apply.

Of course, not all investors may wish to engage in socially responsible investment merely for the consequences that result. Instead, some may feel it is morally wrong to profit off certain business activities, regardless of the consequences. Further, socially responsible investors may be motivated by consequences that may not show up in stock prices or that may only manifest beyond some threshold of market adoption.

For instance, they may feel that investing according to one’s values helps foster a broader culture of corporate responsibility, regardless of its impact on stock prices. Or perhaps such investors believe that beyond a certain threshold of SRI adoption, profit-minded investors will no longer have the collective power needed to prevent nonfinancial motives from influencing prices.

The key point, however, is to acknowledge that it shouldn’t be taken for granted that socially responsible strategies are “doing good.” In reality, some strategies may have little or no impact, and each should be evaluated on its own merits. And because socially responsible strategies generally come with a higher cost to consumers, investors should carefully consider both the true costs and benefits of any given strategy, as well as the ways in which a strategy fits within their broader moral perspective, before deciding to become a socially responsible investor.

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